ILS provides crucial portfolio diversification ahead of Super El Niño: VP Bank’s Allgäuer

Whilst it appears that a super El Niño could be on the horizon, a new commentary from VP Bank AG authored by Senior Investment Strategist Bernhard Allgäuer indicates that insurance-linked securities (ILS) can provide portfolio diversification as their returns are driven by natural disasters, rather than financial market turmoil, making them largely uncorrelated with traditional asset classes.

“Currently, probability forecasts from the US National Oceanic and Atmospheric Administration (NOAA) suggest that a super El Niño could be on the horizon from September 2026. The consequences would be extreme weather, which is of particular interest to investors holding insurance-linked securities (ILS) and cat bonds,” Allgäuer explains in his latest update to investors.

Due to the increased likelihood of an El Niño event, a quiet storm season is expected for 2026.

The Colorado State University (CSU) tropical meteorology team recently reduced its seasonal forecast for the 2026 Atlantic hurricane season, citing the high-likelihood of a strong El Niño and the associated increase in vertical wind shear as the primary factor.

In its most recent update, the CSU team revealed that is projecting for seasonal numbers of 9 named storms, 4 hurricanes, just 1 major hurricane and a seasonal ACE Index value of only 50 for the 2026 season.

However, Allgäuer stresses that the returns on ILS depend critically on where hurricanes form and where they move.

“There have been very active storm years in the past when storms either remained over open water or made landfall in less densely populated areas, causing only minor damage. Alternatively, the damage was not insured. Conversely, during periods of low storm activity, a single storm in a densely populated area – such as the Miami metropolitan area – can be sufficient to cause severe damage,” Allgäuer noted.

He continued: “In addition to actual losses, returns on ILS are also driven by the insurance premiums received and the rate of return on the collateral fund. Following the devastating Hurricane Ian in 2022, which caused total losses of over USD 100 billion, coupled with losses on the bond markets due to rising interest rates, insurers’ loss-absorbing capital fell significantly. They were therefore prepared to pay more for reinsurance through ILS. This outsourcing caused insurance premiums to rise from 5% to 11%.”

At the same time, Allgäuer noted that the return on the collateral fund rose to 4.6% following the zero-interest-rate period, which resulted in a peak total return of over 15% in spring 2023.

Allgäuer went on to explain that since then, insurance premiums have managed to normalise most recently to 5.7%, while the total return on all cat bonds available on the market currently stands at 9.4% (in USD) and is therefore still above average.

Importantly, Allgäuer emphasises how ILS can provide diversification, even during exceptional market events.

“ILS plays a role in the portfolio not only as a stable source of returns. In recent years, this asset class has also made a positive contribution to diversification. This is because, unlike other asset classes, ILS offers a high degree of diversification, even during exceptional market events. Whilst natural disasters – the key driver of returns – can occur at the same time as market turmoil, they are largely uncorrelated. ILS is therefore well-suited as a portfolio addition to stabilise portfolios,” he explained.

The Investment Strategist also alludes that government bonds, by contrast, have repeatedly underperformed in recent years, specifically highlighting how following the end of the zero-interest-rate policy, they suffered huge losses in 2022, which have not yet been recouped.

“ILS was able to avoid these losses, as the capital in the collateral fund is tied up for a shorter period and is therefore subject to only very limited interest rate risk.

“Government bonds have repeatedly underperformed during market turmoil, most recently during the Iran conflict. Due to the associated inflation risks, both shares and government bonds suffered losses at the same time. In the past, government bonds have reacted differently to equities, which has helped to stabilise the portfolio, particularly during recessions,” Allgäuer concludes.